The Armed Services Board of Contract Appeal is down again for the second time in the last several months. I will not let this attack on democracy (although I am sure the government has an excellent reason for the prolonged denial of access to this information) stop our discussion of the TSI case.

Back to the recent Armed Services Board of Contract Appeals (ASBCA) Technology Systems, Inc. (TSI) (ASBCA 59577 and the nine areas I believe are worth discussing:

Supporting Material Overhead rate

DCAA auditor independence

DCAA’s right to change their mind in subsequent audits

Tax vs. Book on depreciation issues

Bonuses

Accrued Costs crossing fiscal year

Unapproved subcontractors

An excellent example of DCAA properly developing findings.

Documenting consultants work product

The scratched out areas were discussed in previous articles. Today, I am going to talk about DCAA’s right to change their mind in subsequent audits. Again, I am not a lawyer and this is not legal advice.

DCAA’s Right to Change Their Mind

The disagreement between the ASBCA judges and too much of the 61-page opinion addresses the question of DCAA’s changing its mind from audit to audit and from auditor to auditor. To sum up, the two judges in the majority believe DCAA has a broad right to do so, while the minority judge does not.

I am not going to quote their respective arguments, which coincidently coincides with their website unavailability, because I believe this is a horrible case to address the issue.

If DCAA audits, or chooses not to audit, a subcontractor’s invoices in 2012 and sees nothing wrong; this does not prevent them from looking at the subcontractor’s new invoices in 2013 and deciding there is something wrong. All of the extensive legal arguments between the judges aside, the ability to look at costs fresh from year to year is simply common sense to me. This is not absolute but generally true.

One obvious area where DCAA must change its opinion is when there a change in law, regulation, or GAAP.

Does this infer that I believe DCAA is allowed to change their mind at any time and without any constraint? NO, IT DOES NOT. I just believe, despite the pages and pages dedicated to the issue, that this was not the case to explore DCAA’s mind changing abilities.

Let us look at some areas where I believe DCAA’s ability to change its mind is limited.

Reasonableness

Underlying this, as is often the case with DCAA, is the fundamental issues surrounding burden of proof. DCAA auditors can propose findings based on two conclusions: first; the finding is based on a violation of statute, regulation, or GAAP[1]; second; the finding is based on DCAA’s assertion that the cost is unreasonable or imprudent.

If a subsequent DCAA auditor objects to a cost that a previous DCAA auditor allowed because the previous auditor missed an applicable regulation, then the new DCAA auditor is not only within rights to question, but is ethically obligated to proceed with the finding development. However; if the proposed finding is based on reasonableness (or unreasonableness), I believe the contractor enjoys a strong argument that the actions of the previous auditor establish the cost was reasonable and that the personal differences in auditors cannot form the basis for a finding.

Implicit in this is the assumption that both auditors actually sampled and audited the cost. If the first auditor did not actually sample and audit the cost, there is no assumption made.

Sometimes I believe the only person some DCAA auditors lacks respect for more than a contractor is another DCAA auditor. It does not surprise me that this second guessing occurs frequently, but I have now provided a basis for evaluation and objection.

For a closer look at burden of proof issues, look at these previous articles.

Documentation

Another common area where we witness disputes between prior and present DCAA auditors is regarding documentation. The first auditor accepts the documentation while the subsequent auditor does not. Again, there is the assumption the first auditor actually sampled and reviewed the documentation. Again, if there is a SRG issue, especially a change in one of them, I believe the subsequent auditor has the right to raise the issue.

In most cases, the difference arises out of a different interpretation of the SRG. A good example is how some auditors read the requirement for consultant documentation. We will discuss this thoroughly in a future article on this case, but I will just point out that the judges noted that the subsequent DCAA’s auditor’s interpretation of the regulation on consultant documentation was wrong.

Where the documentation is basically identical, the issue gets a bit trickier. As the recent Lockheed Martin case asserted (I would link it if the website was up), inadequate documentation is not a reasonable and prudent argument. Because of this the burden of proof that the documentation is inadequate rests with the government auditor. Now the auditor has to demonstrate the documentation is inadequate despite the previous auditor’s acceptance. I think that is a challenge, but not an impossible one.

Policy and Procedure

Where DCAA should respect prior audit opinions is in the area of a contractor’s policies and procedures, and accounting structure.

DCAA recommended approval of an accounting system is a positive assertion on their part that the contractor’s accounting system is adequate for government contracting purposes. This is done by the auditor signing the SF 1408.

Some consultants sign the SF1408 and argue that this is the contractor’s privilege. I absolutely believe this is contrary to the regulation and it also takes away the DCAA signature accepting your accounting system and the positive assurance I am talking about.

I would argue that if it is covered by the SF 1408, the contractor and the government is provided assurance by DCAA that the system, to include policies and procedures is adequate.

“A logical and consistent method for the allocation of indirect costs to intermediate and final cost objectives. (A contract is final cost objective.).”

There is a critical grammar mistake on the government’s part (is it “A contract is a final cost objective” or “A contract is the final cost objective”?).

Grammar question aside, an approved SF 1408 is an approval of the contractor’s allocation method (Total Cost Input, Value Added, or otherwise). DCAA should not subsequently object to the contractor’s allocation method unless there is a change (SRG or internal).

The SF 1408 is not comprehensive even if your policies and procedures are. Unfortunately, this does not mean that, as part of the process, when you send DCAA your hundred-page accounting policies and procedures you can assume they are all approved. I would only assume the ones covered by the SF 1408 are.

The best example of this are bonuses, which are not addressed in the SF 1408.

TSI believed they addressed the issue with DCAA. Their bonus plan was new to the year that was the subject of the audit findings and the appeals case. Before the submission they started a discussion on the bonus plan with DCAA :

“Mr. Fletcher testified that he met with DCAA auditor Marie Pepin for approximately two hours on 28 February 2008 to discuss the ICP for FY 2007 that would be submitted later in 2008, and raised the executive bonus plan with her during this discussion (tr. 2/121-22). According to Mr. Fletcher, Ms. Pepin said words to the effect of “this looks good to me,” and then they moved on to other subjects (tr. 2/123). We find, as a matter of fact, that this discussion was relatively short and superficial in nature and did not constitute any representation that the government gave final approval to the bonus plan as proposed or executed.”

I wonder if the court would have thought differently if TSI had employed my recommended procedures and followed up the meeting with an email documenting the agreement and attaching the plan?

If TSI had sent that email, we might have had a good case for deciding when and how DCAA can change its mind, even if DCAA ignored the email.

[1] I am going to refer to proposed findings based on statute, regulation or GAAP as “SRG” for the rest of this article.

Let us take a break from the Technology Services, Inc (TSI) case and talk about a continuing flaw in most small government contractor’s accounting system: tracking variances, specifically those associated with cost type contracts and the associated indirect costs.

Simply put, the variance is the amount the government owes you because your rates ran higher than your billing rates or the amount you owe the government because your rates ran lower than the billing rates.

FAR 42.704 provides the CO (or cognizant Federal agency official) or auditor responsible for establishing the final indirect cost rates also shall be responsible for determining the billing rates. The Government allows interim payments, if authorized by the contract, during contract performance by progress payments for fixed-price contracts, or by public voucher for cost-type contracts. Reimbursement of indirect costs for these payments is generally made through billing rates that are established to approximately equal the expected final indirect cost rates for the contractor’s fiscal period, as adjusted for any unallowable costs. These billing rates are used for interim reimbursement purposes until settlement is reached on final rates after the end of the contractor’s fiscal year. Billing rates may be prospectively or retroactively revised by mutual agreement, at either the Government’s or contractor’s request, to prevent substantial overpayment or underpayment. Once the final rates are established, an adjustment is made for any variance between the billing and final rates.

Upon receipt of the certified final indirect cost rate proposal, FAR 42.704(e) provides that the Government and the contractor may mutually agree to revise billing rates to reflect the certified proposed indirect cost rates. The proposed indirect rates will be adjusted to reflect historically disallowed amounts from prior audits until the proposal has been audited and settled. The historical decrement will be determined by either the CO or the auditor responsible for determining final indirect cost rates. If billed costs exceed claimed costs, the contractor must appropriately adjust the next voucher or remit or otherwise credit the Government for the difference.

This government publication points to one of the critical knowledge areas for small business government contractors. If you keep your books and accordingly run your business like the IRS wants their information, your will probably go out of business. If you do the same with regards to DCAA, you will almost certainly go out of business.

The IRS wants to collect information in a manner that makes it easier to assess your tax liability and collect the taxes. They simply have no interest in how your business is doing, your success or failure is not within their job description. DCAA enjoys a theoretical interest in a contractor’s success as it assumes that the contractor’s work is necessary to the government, but their institutional focus has been on the contractor’s expenses in terms of allocability and allowability. Profitability, to DCAA, is, at best, out of their scope of work. At worst, contractor profits can be a focus of suspicion for DCAA.

And variances have a direct impact on profitability and the ability of the contractor to succeed and prosper. Here are a couple examples from my work over the years:

A couple of decades ago, a contractor I worked with secured a $10,000,000 contract with the government and managed to talk them into a $5,000,000 advance payment on the contract. Almost unheard of, even back in those days.

Unfortunately, the owner died tragically just after receiving the advance payment. The company made the IRS happy and paid the taxes on the $5,000,000 and recorded the “revenue” on the books. Properly, the company should have booked the advance payment as Deferred Revenue, a liability, and the money should only have hit revenue as it was earned. This is an excellent example of how you fill out your tax return often should have no influence on how you manage your business.

I am sure you can guess, the contractor spent a lot of the money before they even began serious work on the contract and struggled for a couple of years to do the work without any new money for the work.

In another example going the other way, a client of mine brought me in to work some audit issues on a $27,000,000 contract. As I looked everything over, I asked about any variances and they assured me there were no variances. I looked at the billing for the five years and could not see any variance billing, and asked to take a look at one year to check. After some resistance, they agreed and I found they underbilled the government about $75,000 in the sample year. That justified taking a look at all five years and the amount grew to approximately $900,000 never billed to the government.

The latter one annoyed me a bit as this contractor paid me to help create their policies and procedures. These policies and procedures called on the contractor to track the variance on a monthly basis. Obviously this did not happen.

Other contractors I worked with over the years discovered during the preparation of their Incurred Cost Proposal that they owed the government tens of thousands of dollars they did not anticipate. Another former client never had a variance, his books somehow tied exactly to the billing rate year after year. It is a bit more innocent than it sounds. He actually thought he was contractually obligated to spend to that amount exactly.

And of course I have to mention the major accounting firm that called an emergency conference call because they did not understand why the rates on the incurred cost proposals differed from the billing rates.

Tracking variances is cost accounting 101. No one should be surprised by a variance. Contractors should track the variance on each contract each month. You calculate the variance (actual vs. billed) for the month and post the difference to the balance sheet. If you the variance is up one month and down the next, this method will show the contract-to-date total each month. Putting the variance on the books of record and reporting it on the balance sheet formalizes the process, making it a routine item to discuss at those monthly finance meetings.

After writing the first draft of this article this morning I reviewed standard report from one the popular government contracting system and discovered, to my great annoyance, that the variance was reported as an increase of profits!!!! How do you explain this to your boss when you have to pay the money back? Maybe it is a setup issue, sigh….

There is some disagreement about where on the balance sheet to post the variance. I prefer to post the balances to an accounts receivable account (“CPFF Variance”) and the offset is to “CPFF Variance Revenue”. Some contractors use an inventory method, posting the variance to an inventory Work in Progress account on the balance sheet and posting the other side to a Cost of Goods Sold account.

Either way, you know where you are each month and there are no surprises.

What do you do if you are caught by surprise? Depending on your circumstances, there are some legitimate methods for addressing variances starting with a thorough analysis of allocability, allowability, and costs.

Back to the recent Armed Services Board of Contract Appeals (ASBCA) Technology Systems, Inc. (TSI) (ASBCA 59577 and the nine areas I believe are worth discussing:

Supporting Material Overhead rate

DCAA auditor independence

DCAA’s right to change their mind in subsequent audits

Tax vs. Book on depreciation issues

Bonuses

Accrued Costs crossing fiscal year

Unapproved subcontractors

An excellent example of DCAA properly developing findings.

Documenting consultants work product

The scratched out areas were discussed in previous articles. Today, I am going to talk about DCAA auditor independence. Again, I am not a lawyer and this is not legal advice.

DCAA Auditor Independence

CPA ethics drove me insane for years before I took the exam and the subsequent ethics exam. I often compare the profession’s complicated ethics rule to the Pharisees described in the New Testament. But beyond the esoteric ethic issues surrounding the audit of the town’s only bank by the town’s only CPA who is a customer of the bank, I want to focus on a couple of simple clear issues regarding DCAA auditor independence.

First, there is the general issue of questioning DCAA’s very ability to be independent. DCAA works for the government, often they work directly for the contractor’s “customer” DCMA. DCAA actually advertises their job as not finding the truth but finding “unallowable” tax dollars. From a common sense point, not a great argument for independence. As a comparison, I do not see the IRS’s primary focus on recovering tax dollars. The focus there seems a little more skewed toward finding the facts (truth).

While I may question DCAA’s institutional ability to be independent, I acknowledge they are granted this assumption of independence by statute. While DCAA in fact, may not be independent, such independence is assumed in order for the government to protect tax payers.

Some of the alternative’s may be worse. I have argued that the government hiring of outside CPA firms to conduct incurred cost proposal audits as destroying even the institutional illusion of independence. The outside CPA firms are contractors looking to keep the contract while, for good or bad, DCAA auditors enjoy some job security and thus a bit more independence. I even referred to the CPA firm contractors as “contractors” in management responses. Outside CPA firms are even more strongly motivated than DCAA to find “unallowable” costs on behalf of their actual customer.

Again, while moaning about the possible illusionary independence of DCAA, I accept it as an institution. This brings us to the second level of auditor independence: those cases where individual auditors, offices, branches, or even the institution abandon the illusionary independence and act in an unethical manner. There are those rare occasions when an auditor is “on a witch hunt” for the contractor, or at least the contractor comes to believe this.

The issue is discussed in several paragraphs of the TSI opinion on both the actual opinion and the dissenting opinion. The following paragraph gets to the heart of the matter:

TSI advances two somewhat related factual allegations that are relevant to its course of conduct legal theory, which we will discuss shortly: first, that the DCAA auditor who performed the initial work on the FY 2007 ICP audit was, for some unstated reason, biased against TSI; and second, that the DCAA had been much easier on it in past audits (app. br. at 3-5; app. reply br. at 10-11). In testimony presented by TSI, Mr. Fletcher, its CFO, characterized the first DCAA auditor, Ms. Waller, as having been “on a witch hunt” (tr. 2/165). Moreover, as discussed above, there was ample evidence of friction between Ms. Waller and TSI and early indications from TSI that it did not believe that it would get a “fair” audit from Ms. Waller. Nevertheless, the evidence also demonstrates that the preliminary work performed by Ms. Waller was not the end of the story, given the change in questioned costs demonstrated most clearly by Tables 1, 2, and 3 above. Moreover, the ACO credibly testified that her decisions regarding which costs to question were made independently (tr. 1/251 ), which is consistent with the back-and-forth which she attempted with TSI prior to issuing her COFD. We need not delve into these circumstances any further due to the fact that TSI, itself, has “concede[ d]” that its claim that the COFD should be set aside due to lack of auditor independence “cannot be sustained” (app. br. at 3).

Off the top of my head, I do not recall an incident where I concluded that a DCAA auditor’s personal bias interfered with an audit, but there were many occasions where the contractor thought so and I understood how they came to this belief. To be frank, I believe contractors take personally an auditor’s professional incompetence and see this incompetence as a witch hunt. Professional competence is not simply technical but also encompasses behavior with the audit subject, and not all DCAA auditors show a mastery of this area and some of them experience a strong reaction when a contractor questions their actions or requests.

All of this simply reminds us that DCAA auditors are human beings working, in my opinion, in a less than ideal envrioment. They are asked to function as independent auditors in a instution that places enormous value on finding contractor errors. I do believe the vast majority of them rise above this pressure.

Another example of where it appears personal is when we remember that DCAA auditors are thrust out on audits with a great deal of authority and not always the experience, knowledge, or support, to exercise that power in the best way possible. DCAA is working hard to address this issue, but the last crisis took a serious toll on the agency’s institutional knowledge. I remember a young DCAA auditor threatening me with a fraud referral because he concluded that a working trial balance was an instrument to defraud the government. Many such auditors are now supervisors.

There are many findings of auditor incompetence, even serious allegations of DCAA malpractice, but I believe it is rarely, if ever, personal.

What is interesting about the TSI case is that all three of the judges were willing to look at evidence of bias. That is a warning shot across the bow of the ship DCAA.